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Trade war threat?

24 August 2018

While there are a number of global issues worrying investors, protectionism may be the most immediate.

Republicans are supposed to like free trade – and so is the US. But much has changed under the current presidency, which has acted on its view that current trade rules are unfair, making it all the harder for investors to forecast what lies ahead.

Many US companies have enjoyed the tailwind of the US president’s tax cuts, introduced late last year, and the cuts’ effect continues to show up in healthy US corporate earnings. Donald Trump’s trade tariffs, however, risk pushing in the opposite direction. Intended as a boost to US companies, some are already feeling a negative impact.

Harley-Davidson, for example, announced just a few weeks ago that it would need to cut jobs in the US due to the EU’s retaliatory tariffs against the US – the company said that EU tariffs on its two-wheelers had risen from 6% to 31%, adding $2,200 to the cost of a motorcycle exported from the US to Europe.1 Other companies had hoped or even expected to benefit from tariffs, among them Whirlpool, the home appliance manufacturer, and Alcoa, the aluminium producer. Yet both reported disappointing second quarter results, and said that higher import costs were partly to blame.2 Moreover, around 40% of S&P 500 companies mentioned tariffs in their second quarter earnings call – up from below 17% in the previous quarter.3

Yet in many ways, the reaction on markets has been fairly contained. Trade growth has already slowed in recent months, although not reversed, and the US is expected to decide this year on whether to impose tariffs on a further $200 billion of imports from China4 – the first two rounds of US measures have added up to tariffs of $50 billion on imports from China. Chinese stocks have had a rough 2018, but that may have as much to do with slowing growth as anything trade-related. Are markets right to treat the risk as so limited?

“On Europe and on NAFTA [North American Free Trade Agreement], I think Trump is really just going for a transaction to even up some tariffs and do a deal – those issues are not a strategic focus for the long run,” says Hamish Douglass of Magellan Asset Management, manager of the St. James’s Place International Equity fund and co-manager of the Global Growth fund.

“The China issue is a lot more complicated because there is a deeper long-term strategic issue and, at the centre of that, are some strategic industries that are in a 2025 Chinese development plan – supercomputers, semiconductors, 5G telecoms networks, driverless cars and artificial intelligence. China wants a dominant stake. And so, at the centre of the US–China dispute, is technology and who is going to reign supreme,” says Douglass.

Push and pull

As a recent report by Capital Economics pointed out, some countries are pushing back against tariffs.5 In July, the EU and Japan signed the largest trade deal in history. And following Trump’s withdrawal from Trans-Pacific Partnership, the 11 remaining members have signed TPP-11.

Yet the reality is that the US–China relationship is particularly significant for global trade. The US sets the pace for the global economy, while China contributes more than a third of the world’s annual GDP growth.6 The US imports more than any country worldwide in dollar terms, while China is the world’s largest exporter.7 As a result, while the markets are sensitive to all kinds of global spats in the short term, a US–China trade war has the potential to cause the most damage.

Corporate fallout

Yet if the best equity investors are cognisant of macroeconomic risks, it is always with a view to understanding how they could affect individual stocks. Jim Henderson of Aristotle Capital Management in California, manager of the St. James's Place North America fund, argues that managers should always prioritise long-term secular business drivers in their deliberations over stocks, and consider macro themes primarily in that context. On that basis, he argues it would be wrong to view the current trade spat as the key long-term driver of company performance, even in the most adversely affected sectors.

"We tend to place more weight on factors that will affect businesses on more of a secular basis while understanding that shorter-term factors can effect shorter-term results - the current trade spat falls into the latter category," says Henderson. "We fall into the Milton Freidman camp, which means we believe that capitalism and generally free and fair trade has done more to lift economies - and people - from poverty than any other system. But the operative word is “fair”. Each country tends to operate in the enlightened sense of self interest and from time to time the system can get off kilter. We appear to be at one of those times. Trying to predict the outcome of what is essentially a political process is futile. Could this process have a short-term impact on some of our investments? Yes, it could. However, at least as of now, the chances of the current battle affecting long-term business values are remote."

But if US businesses are vulnerable to a ramping up of tariffs, Chinese businesses are arguably more so, given the size of China's trade surplus with the US. Should those investing in the region hold back?

"China’s auto component manufacturers, technology hardware, textiles and fashions are relatively vulnerable to tariffs, but exports make a much lower contribution to China’s economy than they used to - besides, if the trade issues continue, we would expect economic reforms to be an even greater focus for the Chinese administration; perhaps even accelerated in an attempt to offset the negative impact," says Alistair Thompson of First State Stewart Asia in Singapore, manager of the St. James's Place Asia Pacific fund. "Most of our China holdings should see little direct impact from a trade war. We own companies like Shanghai International Airport, which benefits from increased tourism and higher spending on airport duty free goods, as well as gas companies ENN Energy and Hong Kong & China Gas, which benefit from China’s switch to cleaner energy sources. Their success is underpinned by conservative management, dominant franchises, and long-term secular growth drivers."

Indeed, two recent reports by Capital Economics express the expectation that trade tariffs are unlikely to cause an outright economic or business slump. In an extreme scenario, whereby tariffs of 25% were placed on all goods, global growth would lose two to three percentage points.8 That’s a significant enough hit for investors to need to monitor developments, but it lies at the outer reaches of the range of possibilities.

“If we saw a trade war between the US and China – and, to be clear, we’re not in one yet – then all stock markets could be affected,” says Magellan’s Douglass. “Outside of China and Hong Kong, the markets seem to be pricing for a deal getting done, and for this not turning deep and ugly. If Trump just wants a deal he can sell to the American public, then I think China would agree, in a heartbeat, to buy a few US planes to help ease tensions . But if he wants to dig in to resolve the question of who has long-term technological supremacy, then it’s a deeper, longer, uglier scenario.”

The value of an investment with St. James's Place will be directly linked to the performance of the funds you select, which may go down as well as up. You may get back less than you invested.

Aristotle Capital Management, First State Stewart Asia and Magellan Asset Management are fund managers for St. James's Place.

The opinions expressed are those of Jim Henderson of Aristotle Capital Management, Alistair Thompson of First State Stewart Asia and Hamish Douglass of Magellan Asset Management and are subject to change at any time due to changes in market or economic conditions. This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell securities or to adopt any strategy. The views are not necessarily shared by other investment managers of St. James's Place Wealth Management.

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